Algorithmic Trading is the use of electronic platform for placing trading orders with an algorithm deciding the timing, price and size of orders. High Frequency Trading (HFT) is a special class of algorithmic trading in which trading systems make trading decisions based on the information they receive electronically before human traders are capable of processing the information they observe.
Lets see how algorithmic trading minimizes market impact. All the orders placed can be classified either as Market Orders or Limit Orders. Markets orders want the exchange to execute the order in the best possible price. So, if you want to buy, the exchange will find the seller who is willing to sell at the lowest possible price and execute the order. Limit Ordrs on th other hand specify the limit on the negative side. These limit orders are not executed right away and they stay in the book for some time. These live but non executed orders form what is called the order book. Lets say I place a Market Order to buy 1 million Yahoo shares. The exchange will try to find the best seller which is selling at the least price and then the next best and so on, till the I get 1 million shares. This means that the execution price is going to be poor. On the other hand if I place a limit order. Now, the exchange will execute whatever it can but it will stop as soon as there are no more sell side orders with favorable price. Once this is done, your order becomes part of order book. Once everyone, including other algorithms, sees such a massive order sitting on the buy side, price is bound to rise sharply.
However, algorithmic trading has generally been a sell-side product. This means that institutional brokers are the ones who actually have the systems for placing and managing algorithmic orders. Institutional traders place Algo orders with brokers who submit the orders either programatically from automated systems or manually through user interfaces. Institutional brokers and investors have invested a lot of time and money on Algo trading systems over the years.
Lets look at one of the simplest algorithmic strategies :
The basic rule is to start with an initial order size and keep increasing or decreasing the size of order. The first question that comes to mind is when to increase and when to decrease the size of order. The answer depends on whether the market is in mean reversion mode or is trending towards one direction. If you a buyer and the price continues to drop, then it makes sense to wait for some time as the price is going to be more lucrative. On the other hand, if the market is in mean reversion mode, the trend is not going to last for ever and so we need to increase the size whenever price becomes favorable.
The next question is how to predict the market. Well, truly speaking, nobody can predict the market. We just try to be correct more often than we are wrong. This is where high frequency trading comes into picture which helps us to predict the market by analyzing the market trends quickly.
Who is suited for Algorithmic Trading ?
The most important reason for going for algorithmic trading is to control the market impact while placing big orders and thus seek favorable prices. Anyone who places big orders needs to worry about the market impact. As a thumb rule, if the size of order exceeds the sum of best 5 levels you need to worry about the market impact. Big institutions like pension fund managers, investment banks, hedge funds, etc. are the ones who place Algo orders.Lets see how algorithmic trading minimizes market impact. All the orders placed can be classified either as Market Orders or Limit Orders. Markets orders want the exchange to execute the order in the best possible price. So, if you want to buy, the exchange will find the seller who is willing to sell at the lowest possible price and execute the order. Limit Ordrs on th other hand specify the limit on the negative side. These limit orders are not executed right away and they stay in the book for some time. These live but non executed orders form what is called the order book. Lets say I place a Market Order to buy 1 million Yahoo shares. The exchange will try to find the best seller which is selling at the least price and then the next best and so on, till the I get 1 million shares. This means that the execution price is going to be poor. On the other hand if I place a limit order. Now, the exchange will execute whatever it can but it will stop as soon as there are no more sell side orders with favorable price. Once this is done, your order becomes part of order book. Once everyone, including other algorithms, sees such a massive order sitting on the buy side, price is bound to rise sharply.
However, algorithmic trading has generally been a sell-side product. This means that institutional brokers are the ones who actually have the systems for placing and managing algorithmic orders. Institutional traders place Algo orders with brokers who submit the orders either programatically from automated systems or manually through user interfaces. Institutional brokers and investors have invested a lot of time and money on Algo trading systems over the years.
Lets look at one of the simplest algorithmic strategies :
TWAP (Time Weighted Average Price) trading strategy :
TWAP breaks a big orders into smaller chucks of orders which are executed after a fixed interval. But a simple algorithm or even a smart trader can figure out this pattern by looking at the order book. So, nearly all production TWAP algorithms involve some type of randomization. This randomization can be done in terms of the sizes of orders or in terms of the intervals between the orders or both.The basic rule is to start with an initial order size and keep increasing or decreasing the size of order. The first question that comes to mind is when to increase and when to decrease the size of order. The answer depends on whether the market is in mean reversion mode or is trending towards one direction. If you a buyer and the price continues to drop, then it makes sense to wait for some time as the price is going to be more lucrative. On the other hand, if the market is in mean reversion mode, the trend is not going to last for ever and so we need to increase the size whenever price becomes favorable.
The next question is how to predict the market. Well, truly speaking, nobody can predict the market. We just try to be correct more often than we are wrong. This is where high frequency trading comes into picture which helps us to predict the market by analyzing the market trends quickly.
To analyze commodity market is not so easy for everyone. The person who completed relevant study & research how the market works can only guide & suggest about the market movement. So always get experts guidance to maximize your commodity profit.
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Commodity Tips Provider
This is a very naive strategy to help us understand the basics and would never be used in production. The actual strategies are much more complex and they take into account a lot of factors.
DeleteThere are algorithms to predict market movement which are developed by experts who have done extensive research in this area. But truly speaking, no algorithm can predict the market correctly always. In that case, the system would be a money making machine.